value and opportunity

Quick “Management summary”:

Within the large UK banking peers, only Lloyds banking Group offers a “pure play” Uk opportunity. There are a lot of negatives around UK banking in general and Lloyds specifically, but overall nothing which would “kill” the investment at this stage. Potentially, the current selling of the UK government and the visible turn around could present an attractive entry point for a turn around situation with kind of “catalyst” if Government at some point is finished and profit increases ex fines.

Following my Aldermore post a few days ago, I decided to have a closer look into the listed UK banks as the UK market looks structurally more interesting than most European ones. Overall valuations are pretty moderate. This is a table based on the most recent financial year:

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Name	P/B	P/TB	Leverage	NIM	Pers. Exp	P/E
HSBC HOLDINGS PLC	0,88	1,03	13,17	2,08%	33,25%	12,5
BARCLAYS PLC	0,77	0,90	22,03	0,00%	43,52%	#N/A N/A
ROYAL BANK OF SCOTLAND GROUP	0,71	0,82	17,46	1,83%	38,00%	101,2
STANDARD CHARTERED PLC	0,90	1,01	15,53	2,15%	37,02%	16,5
LLOYDS BANKING GROUP PLC	1,19	1,30	17,13	1,33%	28,40%	51,7

Looking at the list of banks, lets look quickly at the different players.

1. HSBC

HSBC is by far the biggest player with the clear target to be one of the biggest players globaly, offering all services from investment banking to private banking, etc. Their UK business is a rather small part of the company, the biggest part of the business comes from Asia. Historically, HSBC has always been trading at least at 2x book value. The company has been involved in many scandals, the problems of the Swiss subsidiary and the secret bank account of the CEO are only the latest example. Overall, HSBC is much more a play on Asia than anything else.

2. Barclays

Barclay’s is in its core an investment bank with some retail businesses attached. They took over large parts of Lehman following the financial crisis. Barclay’s has significant revenues from card processing and African operations. As with HSBC, UK retail is not their main focus.

3. Royal Bank of Scotland

The creation of “Fred the Shred”, had to be bailed out by the British Government in 2008. The Government still owns more than 60%. Among others, RBS is obliged to dispose US subsidiary Citizen’s which I own as a “special situation”. RBS is (still) a full service bank, including investment banking and wealth management. RBS is still in the middle of restructurings, for instance just a few days ago they announced to drastically shrink Non-UK investment banking.

4. Standard Chartered

Although Standard Charteres is UK listed, it basically does not do any business in the UK. It is an international commercial bank active mostly in Asia and Africa. The CEO has been recently replaced and the share price has recovered. Historically, as HSBC, Standard Chartered used to trade at much higher mutiples.

5. Lloyds Banking Group

After the disastrous HBOS acquisition in 2008, Lloyds had to be bailed out by the British government. the Government still owns 23% and is in the process of selling down. As part of the reorganization, Lloyd’s IPOed TSB and scaled back the international business. Lloyd’s is an almost “pure play” UK bank with the largest share in UK business of all the players. After the spin-off of TSB, they still have on average ~20% market share which to my knowledge is pretty unique for a private bank in a Western country.

So LLoyd’s in principle is the only interesting “play” to invest into UK banking. But is it worth the effort to dig deeper ?

As always, the first step is: Try to kill the investment case

This is the list I came up with after reading the 2014 annual report plus some “well known facts” about banks:

1. Lloyds had to pay massive fines, among others for misselling PPI insurance, Libor fixing etc and there is more to come
2. The UK Government still owns ~23% and is selling
3. Uk banking is very unpopular in the public’s mind which is bad for business
4. UK bank levy has been extended
5. 3 officers get 21 mn in 2014 despite tiny profit, bonus for”underlying profit”
6. huge pension plan (funded, derisked)
7. UK housing is overheated
8. In the next financial crisis, all banks will crash again
9. Valuation is high compared to “peers”
10. They only pay a tiny dividend
11. Risk of UK election outcome and UK exit
12. The banking business model is dead

1. Fines/PPI

This is a quote form the annual report:

PPI
The Group increased the provision for expected PPI costs by a further £700 million in the fourth quarter. This brings the amount provided in 2014 to £2,200 million (2013: £3,050 million), and the total amount provided to £12,025 million. Total costs incurred in the fourth quarter were £700 million and as at 31 December 2014, £2,549 million or 21 per cent of the total provision, remained unutilised.

So they do have still a 2 bn GBP provision for additional claims. Overall, the PPI episode was clearly a major issue for them. But on the other hand, there is some reason to believe that we have seen the peak. I am no expert in this, but if the provision would be enough, we could see rapidly increasing earnings over the next 1-3 years. Reading through the annual report, it looks like that they should not expect any US fines and also most FX/Libor related fines should be closed. But there clearly remains a risk.

2. Government stake / selling

In December, the UK Government decided to “dribble” the stocks into the market and against a one time big sale. A few days ago they released that they had sold 1% down. This constant selling is of course not good for the shareprice. The “break even” for the Government seems to be 73,6 pence, so one could expect that they are constantly in the market for the time being. This is clearly bad for traders but not necessarily for long term investors.

Looking at the chart, it seems that there is a “lid on the price” at around 80 pence since more than a year:

Forced sellers or in this case sellers who don’t want to maximise their long term return are often moving prices into “non-effecient” areas. As we value investors know, price is not equal value. So the classic “share overhang we have here might be a reason to actually look deeper into the value of the stock as there is a good chance that without those sales, the share price could be higher.

3. Bad reputation

Banking in general and UK banks in particular are maybe one of the most hated companies at the moment. As I have written, many small players try to take advantage of this like Aldermore, Handelsbanken or Virgin Money. Plus, the UK banks lose most law suits as judges mostly side with the plaintifs. The question clearly is if this will hurt the big players all over and long term or if there will be winners and losers for the big players. My personal opinion is that LLoyds as a focused UK player is in a better position to turn around the image than for instance RBS, HSBC or Barclays who have other problems to solve. I will look at this later but in my opinion the main victims will be the “weaker” players, not Lloyds Bank.

Bad reputation on the other side can be interesting for an investor. When no one wants to touch a stock, it is usually more likely a value investment than if everyone is talking on cocktail parties on how great a company does.

4. UK Bank levy

As a direct result of the bad reputation, the UK government had introduced a bank tax (“levy”) as a percentage point of the full balance sheet after the financial crisis. Currently it is ~0,21% for the whole balance sheet amount, a very significant expense especially for banks which have a lot of non-Uk business (Standard Chartered, HSBC). There is clearly a risk that a socialist UK Government will keep or even increase the tax. On the other hand, corporate taxes in the uk went down a lot which kind of off sets this issue compared to non-UK peers.

5. Large bonuses 2014

Especially the CEO, Antonio Horta-Osorio made around 11 mn GBP in 2014 which caused some uproar in the UK press. However most of that was a result of a 3 year plan which vested this year. On the other hand, he turned down a bonus of 2 mn in 2012 and received most of his bonus in stocks which he pledged not to sell until the government is out. As management plays a big role at banks, I will need to look deeper into the CEO at a later stage. Comapring older annual rpeorts, they have dropped their initial target from 2012 to earn 12-15% ROE in the long term.

6. Large pension plan

To be honest, Lloyd’s pension plan is not only huge but GIGANTIC. The current DBO liability is 38 bn GBP not much less than the total core equity position. The bad news: The discount rate the use with 3,67% is pretty high, on the other hand, they have derisked the plan early. of the 38 bn assets, only 5 bn are equity. Additionally, they seemed to have actively closed a large part of the interest rate risk in 2014. This is the statement from the annual report:

The asset‑liability matching strategy currently mitigates approximately 89 per cent (2013: 54 per cent) of the interest rate volatility and 94 per cent (2013: 71 per cent) of the inflation rate volatility of the liabilities.

This was very fortunate or clever timing and might have spared them a couple of billions over the last few months. For pension plans, this is clearly best in class with regard to ALM. Nevertheless a big pension plan like this will eat up a lot of capital and risk bearing capacity for the company and is clearly a big negative factor.

7. UK housing is overheated

I am not an expert in UK housing, but my assumption is that they are better prepared than last time.

8. In the next financial crisis, all banks will crash again

As I have mentioned before, I do think the banking sector overall is much more stable than in 2007. the next crisis will come from somewhere else and the major victims will be other players.

9. Valuation is high compared to “peers”

Yes, at first sight it looks expensive, but in my opinion, Lloyds is already 1-2 years ahead compared for instance with RBS. The have cleaned up the organization and the portfolio

10. They only pay a tiny dividend

Compared to the 6% of HSBC, Lloyd’s tiny dividend looks ridiculous. However this could change quickly and Lloyds could become interesting for dividend investors.

11. Risk of UK election outcome and UK exit

Valid concern, however I tend to ignore such macro stuff. Rather I think it could be an additional explanation for a low valuation.

12. The banking business model is dead

Nope, I do think the “traditional” banking model is here to stay, at least for the banks who do it right.

Summary:

Overall, I would not “kill” the Llyods investment case at this stage. The biggest issue for me is the gargantuan pension plan. Although it seems to be well-managed, it is still HUGE. In a next step, I will need to come up with a valuation or some idea about potential returns for Lloyds and have a closelook at management.

As a side remark: I do see that someone like Handelsbanken could capture market share, especially from guys like RBS or Barclays. A funny side note: Handelsbanken doesn’t even appear as competitor for Lloyds in their 2014 strategy update